Understanding the Importance of Remittances

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Understanding the Importance of Remittances

October 1, 2004

Feature

By Dilip Ratha

Workers’ remittances have become a major source of external development finance, providing a convenient angle from which to approach the complex migration agenda. The development community needs to consider how to best manage remittance flows and how the body of research on remittances can be strengthened, both for the purpose of understanding the impact of remittances and for forming more effective policy for managing remittances. This article looks at these questions and explores ways to improve on the knowledge and impact of remittances in development.

Officially recorded remittances received by developing countries exceeded $93 billion in 2003. The actual size of remittances, including both officially recorded and unrecorded transfers through informal channels, is even larger. Remittances are now more than double the size of net official flows (under $30 billion), and are second only to foreign direct investment (around $133 billion) as a source of external finance for developing countries.

In 36 out of 153 developing countries, remittances are larger than all capital flows, public and private. Also, remittances are stable, and may even be counter-cyclical in times of economic hardship (Figure 1). Moreover, remittances are person-to-person flows, well targeted to the needs of the recipients, who are often poor. They can also be altruistic transfers that do not have to be paid back.

Exorbitant fees – 13 percent on average and frequently as high as 20 percent – charged by money transfer agents are a drain on hard-earned remittances (Figure 2). These fees especially affect the poor. Reducing remittance fees by five percentage points could increase annual remittance flows to developing countries by $4 to $5 billion.

It is difficult to see why remittance fees should be so high, and why they should increase – rather than stay fixed – when the amount of transfer increases. It appears that the regulatory framework is flawed. There seem to be barriers to competition, and perhaps duplication of efforts in the payments system (e.g., each transfer agency investing in its own proprietary transfer system). Fixing this problem would involve policy coordination in both source and destination countries.

Figure 2: Remittance costs from Brussels to any location worldwide

Source: westernunion.com

Improving migrant workers’ access to banking in the remittance-source countries (typically developed countries) would not only reduce costs, but also lead to financial development in many receiving countries. Facilitating remittance flows would require using the existing retail financial infrastructure, such as postal savings banks, commercial banks, or microfinance institutions in rural areas. Also, given that the average cost declines as remittances increase, there may be scope for policy measures that alleviate cash constraints and enable migrants to send larger amounts of funds (though less frequently), thereby saving on remittance costs.

Regulation of Remittance Flows

There is a need to strike a balance between a regulatory regime that minimizes money laundering, terrorist financing, and general financial abuse, and one that facilitates the flow of funds between hard-working migrants and their families back home.

Remitters use informal channels because these channels are cheaper, better suited to transferring funds to remote areas where formal channels do not operate, and offer the advantage of the native language and, on rare occasions, anonymity. Informal channels, however, can be subject to abuse. Strengthening the formal remittance infrastructure by offering the advantages of low cost, expanded reach, and language can shift flows from the informal to the formal sector. Both sender and recipient countries could support migrants’ access to banking by providing them with identification tools.

Development Impact

On the positive side, remittances are believed to reduce poverty, as it is the poor who migrate and send back remittances. But this view has its critics.

It is sometimes argued that remittances may increase inequality, because it is the rich who can migrate and send back remittances, making recipients even richer. These questions should be studied at the macro level using cross-country data, and at the micro level using household surveys. The impact of remittances depends on their use, especially on schooling of children. A recent study from El Salvador shows that the school drop-out rate is lower and the enrollment ratio higher in households that receive remittances.

It's important to consider how remittances may offset the negative effects on economic growth and fiscal revenue of the remittance-receiving country when skilled workers emigrate. The brain drain issue, along with the issue of job competition from in-migration in labor-receiving countries, may well hold the keys to the success of the global migration agenda.

Improving Available Data

Reliable data on remittances are key to understanding the impact of development, yet available data leave much to be desired. Informal remittances are large and indeterminate. But even recorded data are also incomplete. Canada and Denmark, for example, do not report any remittance data.

A major effort will be necessary to improve data on remittances. This effort would have to go beyond simply collating information. It would require investigating the relationship between migration stock and remittance flows, migrant workers’ remittance behavior in major remittance-source countries, and the way remittances respond to changes in the source and destination economies.

Fiscal Incentives

The majority of developing countries offer tax incentives to attract remittances. The side effect of such incentives, of course, is that remittances may then be used for tax evasion and money laundering. Also, a number of governments provide matching funds for remittance-backed projects.

For example, some states in Mexico use a “3-for-1” program, matching every dollar sent by migrant groups with $3 of local government funds to pay for infrastructure projects. This means a school could be rebuilt with $1,000 from migrants and $3,000 from the local government, for a total investment of $4,000. Again, the side effect may be diversion of scarce budgetary resources to projects that non-resident nationals favor. These questions have not been examined seriously yet.

Many aid agencies are looking into using hometown associations (HTAs) to channel aid, but these associations will have limited potential for channeling any significant volume of official funds. However, HTAs might be used to promote community financing of infrastructure or provide other collective funding for community priorities.

Related to the brain drain question is the issue of how governments in labor-sending countries may recover lost taxes resulting from skilled migration. The literature has suggested changing the tax policy from one based on geography (i.e., taxing income guaranteed within the country) to one based on nationality (i.e., taxing nationals even when they reside abroad, similar to the U.S. tax policy).

Conclusion

There is tremendous potential for using remittances to encourage development in countries. Yet, though much progress has been made toward understanding remittances, the limitations mentioned above highlight how their potential impact is significantly reduced.

Learning more about the best ways to capture and make use of remittances will require reconsidering how financial inflows are received in countries. In addition, development policymakers will need much more research on how to use remittances so they positively contribute to migrants’ home communities and countries.